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Many of the products you use everyday, like your CD player and TV set, 
were not designed or manufactured in the United States. Why do you ^ 
have the opportunity to buy and use so many foreign products? 

Story by Cedric fan 
Revised by Steve Malin 
and Radhika Mithal 
Art by Jesse Chen 

The reason is that the United States 
trades goods and services with many other 
nations. Trading practices have changed greatly 
over the years, so we ll start this story 
by looking at trade history. 


After stagnating for several 

i hundred years, the volume 
* of foreign trade increased 

of foreign trade increased 
rapidly in the early 1 500s. 


The European nations, dominant at that 
time, pursued an economic philosophy 
called mercantilism. Mercantilism 
consisted of two main ideas. The first 
was that precious metals determined 
a nation's wealth* 

^ All that gold in the new ^ 
world is providing yet another 
golden opportunity to increase my 
wealth, I can hardly wait for the 
* California gold rush to start 

300 years from now* 4 

We must find new foreign 
markets for our products so 
that our supply of gold and 
silver will increase* 

The second mercantilist idea, directly 
related to the first, was that countries 
should export more than they import. 

During the mercantilist era, exports 
were sold for gold and silver, so a 
nation exporting more than it imported 
would continuously increase its wealth* 

^ You seem to havens 
extra time on your hands 

To export more than they import, mercantilist nations 
focused on finding new natural resources that could be 
processed and manufactured into goods fit for sale abroad* 


The mercantilist 
philosophy was 
challenged by 
the publication 
of Adam Smith’s 
The Wealth Of 
Nations in 1776, 

r As I say in my book, 
the expense of acquiring an 
unnecessary quantity of gold 
and silver will diminish the 
actual, or potential, 

V wealth of a nation, > 

Smith did not share the mercantilists 1 belief that a country^ 
wealth was determined by precious metals. He believed a 
nation s wealth ultimately was determined by its holdings of 
assets, such as household items that consumers desired. 




HE Ot-Df. 


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Smith argued that nations should export 
the surplus of what they were best at 
producing, and use the proceeds of the 
export sales to import what they were less 
good at producing. Only then would the 
true wealth of nations increase. 







Smith pointed out that many nations have natural and acquired advantages in producing 
certain goods. Some countries are rich in natural resources, such as lumber and farmland,,.. 


■II I 

... and others in acquired resources, such as a highly 
trained workforce and a large technology base. These 
countries have an advantage In producing goods such 
as silicon chips, because chip manufacturing requires 
skilled workers and technologically advanced machines. 

These natural and acquired advantages 
ted Smith to introduce the principle 
of absolute advantage. 

A country has an absolute 
advantage in the production of a good or 
service when it can produce that output more 
cheaply than any other country, if countries 
specialize in producing the good in which they have 
an absolute advantage, they can trade what they 
don't need and be better off economically. 

Smith's ideas on trade were 
refined in the early 19 th century, 
when the wealthy bond trader, 
David Ricardo, explained the concept 
of comparative advantage. 

Adam Smith 
wasn't quite right, 
it’s not absolute 
advantage that 
really matters, but 


■B*" If two countries have different j 

f resources and skills, they will have different^ 
relative abilities to produce different goods. ^ 
Both countries will be better off by specializing 
in what they produce most efficiently and trading 
what they don’t need domestically, , 


Ricardo showed that when two nations have 
different relative abilities to produce 
different goods, trade will benefit both nations. 

A simple example will illustrate the concept of 
comparative advantage. Let's assume that the 
United States and a mythical country we'lL call 
Jean stand both produce blue jeans 

and compact discs. . 

Now, suppose it takes 1 hour 
to make a CD and 2 hours to 
make a pair of blue jeans in the 
United States, while it takes 4 hours 
to make a CD and 4 hours to make 
a pair of jeans in Jeansland. 


1 CD 









Note that the United States has an absolute advantage 
in producing both goods. That is, it takes the 
United States fewer hours than Jeansland to manufacture 
either a pair of jeans or a CD. 

Because the United States has an absolute advantage 
in producing both goods, you might think that only 
the United States would benefit from trade. In fact, 
both nations will benefit from trade because 
Jeansland and the United States have different 
relative abilities to produce CDs and jeans. 

Of course, 

Jeansland and the United 
States will benefit onLy if 
they produce different goods 


~ 1 I - 

Since it takes 1 hour to make a CD in the United States and A hours in Jeansland, U.S. workers are four times as 
efficient as Jeansland workers in making CDs. Because it take 2 hours to make a pair of jeans in United States and 
A hours in Jeansland, U.S. workers are only two times as efficient as Jeanstand workers in making jeans. Thus 
we say that U.S. workers are relatively more efficient in the production of CDs than in the production of jeans. 

Alternatively, because it takes 4 hours to make a pair of jeans in Jeanstand and 2 hours in the United States, Jean stand 
workers are Vi as efficient as U.S, workers in making jeans, and because it takes 4 hours to make a CD in Jeansland and 
1 hour in the United States, Jeansland workers are only % as efficient as U.S. workers in making CDs. Therefore, 
Jeansland workers are relatively more efficient in the production of jeans than in the production of CDs. 

- Since Jeansland is relatively ^ 
more efficient in making jeans, 
Jeansland has a comparative advantage 
in the production of jeans. . 

^ Because the United States 
is relatively more efficient 
in producing CDs, the United States 
has a comparative advantage in 
v the production of CDs, 


I Wh ATidid 


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Comparative advantage can also be 
described in terms of opportunity costs 
An opportunity cost is what you give 
up to do something else. 

Opportunity cost is the basis of comparative advantage. 
To see how, suppose U,S, workers at first produce 
only CDs. Producing T CD fewer frees 1 hour, 
with which an American can make Yi pair of jeans. 


Because the opportunity cost of making a CD is lower 
in the United States (1/2 pair of jeans) than in 
Jeansland (a full pair of jeans), Americans have 
a comparative advantage in making CDs. Similarly, 
Jeansland has a comparative advantage in making 
jeans* Can you figure out why? 

jeans, I can save some of my income 
and buy jeans imported from Jeansland* 
However, my plan won’t work unless 
workers in Jeansland choose to make jeans. 

That’s right* Jeansland has a comparative advantage in 
making jeans because the opportunity cost of making 
a pair of jeans is lower in Jeansland (1 CD) than in 
the United States (2 CDs)* 

If Jeansland er$ trade jeans for CDs 
they're trading the good they can produce 
relatively more efficiently for the good 
they produce relatively less efficiently* 

This must be better than the initial 
situation, in which Jeansland produced 
both goods. Likewise, the United States 
must also be better off under trade 
based on comparative advantage. 

If all nations exploit their comparative advantages, alt will be better off and the standard of living of 
each nation will rise. Gross domestic product (GDP), the value of goods and services produced in a country, 
will increase and new jobs will be created in industries that have a comparative advantage. 


It should be noted that the ^ 
Jeansland /United States example 
is a great simplification of what 
happens in the real world. > 

Thus, our example yields 
valuable insight into the 
reasons nations trade. 

In the real world, countries never 
completely specialize in the production 
of one or a few goods, but underlying 
economic factors related to comparative 
advantage do lead to concentration in 
the production of certain goods. 

The important point is that 
countries are better off when they 
exploit their comparative advantages* 
What happens, though, when 
countries nave trade barriers? 


♦ * v 

Two types of trade barriers are tariffs and quotas. 

A tariff is a tax imposed on goods imported into a country. 
For example, the United States might Impose a St tariff 
on all bottles of French wine entering the United States... 

I believe in trade. 
Free trade. 





A quota is a restriction on 
the quantity of a particular 
good entering a nation. 
Most economists oppose 
tariffs and quotas because 
they limit free trade. 
Free trade, in turn, raises 
standards of living when 
countries lower their trade 
barriers simultaneously, 
particularly in countries with 
l developed economies 


— I I 

Several blocs of nations have attempted to lower trade barriers between their members. For example, Mexico, Canada, 
and the United States ratified the North American Free Trade Agreement (NAFTA) in 1993, sharply reducing tariffs and 
easing quotas on goods and services traded within the bloc. Another bloc that has done this Is the European Union (EU). 

















15 U1HMMA 


17. MALTA 





On a broader scale, the World 
Trade Organization (WTO), created 
in 1995 by the Uruguay Rounds of 
negotiations, promotes free trade 
and works to lower trade barriers 
In all nations simultaneously. The 
WTO serves as a forum for its 146 
member countries to establish, 
negotiate, and monitor trade 

There are some reasons why countries might 
elect not to remove all barriers. One is that 
countries want to have domestic suppliers of 
products vital to national security, so they 
won't have to rely on foreign suppliers 
during wartime. 

So, you're > 
telling me you need 
trade barriers until 
ou're well established 
making airplanes? 

Yes, we haven't had 
time to work out all our 
manufacturing problems. 

Another is that many countries want to develop their new and 
struggling industries. Some people say that these new industries 
need the protection of trade barriers in order to mature 
into industries able to compete in the world market. 


A third reason is that white free trade 
tends to make a country as a whole 
better off, this doesn't mean that all its 
population will be made better off. When 
countries specialize in production according 
to comparative advantage, some workers 
will lose their jobs. Inis will lead to 
temporary, or possibly permanent, 
unemployment for some people. 

Returning to our United States /Jeansland example: if, suddenly, 
Jeanslana CD makers lose their jobs because of competition from 
the United States, and U.S. jeans makers lose their jobs because of 
competition from Jeansland, there might be some unpleasant 
short-term problems if the workers carft be retrained quickly 
for new jobs in a different industry. 

The displacement of workers can constitute 
a political and economic problem. This is a — 
major reason why no nation is calling for an i I 

tifMrlfl rtf all traHa karriar* ^ 

immediate lifting of all trade barriers. 

To minimize the hardship on workers, countries 
lower trade barriers slowly, so that with enough 
time, workers can be retrained for new jobs and 
of free trade. 

f —and the Labor Department reported^ 
today that unemployment is inching down. 
In related news, the Commerce Department 
i reported that incomes continued a 
their upward trend. 


So far, we ha vent discussed how trade actually 
takes place. We have simply assumed that countries 

would specialize In what they are relatively most 
efficient at ofoduoinc. and then somehow trade. 

But countries don’t usually trade items 
for other items. For example, a United 
States exporter of compact discs wants 
to be paid in U.S. dollars, not blue jeans. 

To examine how countries actually trade goods and services, we 
lave to introduce money. Most countries have their own currency. £ 
The United States has tne dollar, Japan, the yen. Some countries I 
have a common currency, such as the euro. £ 





One currency is traded for another in the foreign exchange market. 
This market is a network of foreign exchange dealers, mainly in 
large financial centers, who buy and sell various currencies. 

Wow! Some ' 
Dole have a yen 
for trading! j 

Over $1.5 trillion are traded 
daily in foreign exchange 
transactions worldwide. 


Foreign exchange dealers, linked by 
telephones and computers, stand ready 
to list prices at which they wilt buy 
and sell different currencies. 

The dealers earn profits by buying 
currencies at one price and selling 
them at slightly higher prices- 



sal PESOS AT; 


The difference between 
the price of 10.90 pesos 
and price of 1 1 .20 pesos 
is my profit. 

For example, white a dealer might 
be willing to pay 10*90 pesos per 
dollar, the dealer might ask for a 
price of 1 1 ,20 per dollar from 
someone wanting to buy dollars. 

The rate at which one currency is traded for another is known as the 
exchange rate. An exchange rate listed in the United States is usually 
expressed in terms of how many units of a foreign currency one U,S, dollar 
can buy. The Mexican peso exchange rate, for example, might be 10,9 
pesos per dollar. Exceptions include the euro and the U,K, pound sterling, 
which are expressed in dollars per unit of these currencies. 

Large corporations, financial institutions, and government 
agencies need to trade large amounts of currencies on a 
regular basis, either for themselves or (in the case of the 
financial Institutions) for their clients. 


f In contrast, individuals^. 
f and small companies, who \ 
have smaller foreign exchange 
needs, operate in a retail 
environment. As with any retail 
service, they have to pay a 
somewhat higher price. In other 
. words, they receive a less J 
favorable exchange rate. / 

A tourist, for example, 
usually exchanges 
currency at a financial 
institution, typically a 
local bank. 

The bank is 
offering the tourist a 
valuable service. 

The reason the retail foreign exchange (FX, for 
short) customer gets a less favorable rate is that retail 
transactions are usually small and involve paper 
currency, rather than electronic money, so they're 
relatively expensive to execute. 

could execute a dozen 
electronic FX transactions 
for much larger sums. 



MHjMamifc \ \n 

To understand why foreign exchange is important, 
suppose you're atouristina foreign country* say* 
Mexico. You get off the plane and head to a nice 
restaurant because you're hungry. 

How do you do it? U.S. dollars 
wont work; the restaurant 
wants 300 pesos. 

Fortunately, you had changed dollars 
into pesos at the airport bank, and 
you can pay for your meal. 

What happens if you use a credit card to 
pay for your meal? Because the credit card 
company is located in the United States, your 
monthly statement will show the amount 
owed for the Mexican meal in U.S. dollars. 

As is the case with any credit 
card transaction, you don't pay the 
restaurant; rather, your credit card 
company is lending you pesos to 
pay for the Mexican meal. As a 
convenience for you, it will convert 
the pesos into dollars, and show 
the dollar amount owed on 
your billing statement. 




How 3 m I 
going to pay for 
this shipment? 

Some transactions simply take place 
are guessing that the currency they're 
over the short run and they can sell 

because speculators 
buying will appreciate 
it later for a profit. 

Businesses that 
import goods also 
need to exchange 
currency. A U.5. car 
dealer importing 
Japanese cars has 
to find a way to 
pay the Japanese 
for the cars. 

Most FX transactions take place because 
people in one country want to buy real 
and financial assets in another country. 

The Japanese manufacturer wants to be 
paid in yen. not dollars, so the U.5. 
dealer has to find a way to convert some 
dollars into yen to pay for the car shipment. 

Now that you know why 
the foreign exchange 
market is so important, we 
can describe the two primary 
types of transactions that 
take place in the market. 

An immediate currency 
exchange is known as a spot 
transaction. A transaction 
arranged to occur at some 
future date at an exchange 
rate agreed upon 
today is known as a 

To understand the usefulness 
of forward contracts, we can 
use the U.S. importer of 
Japanese cars as an example. 
Suppose that the importers 
next shipment of cars is due 
in one month. 


To pay for the cars, the U.S. importer must find a way to pay the Japanese car maker in yen in one month. 
Suppose that the exchange rate is now 120 yen to the dollar and each car costs 3 million yen. How many 
dollars is this? We compute as follows: (3 million yen) x (SI/120 yen) * $25,000. 

Now suppose that a month later the exchange rate is 100 yen per dollar. What does this mean? At an exchange 
rate of 120 yen per dollar, $1 will buy 120 yen. At an exchange rate of 100 yen per dollar, $1 will buy 100 yen. 
Because the dollar buys fewer yen at the new exchange rate, we say that the dollar has weakened, or depredated. 

! TOP AY: 


Because the dollar has weakened, it now 
takes more dollars to equal 3 million yen. 
How many more? The new exchange rate is 
100 yen per dollar, so 3 million yen will be worth 
(3 million yen) x ($1/100 yen) = $30,000. 
Thus the car is $5,000 more expensive in 
dollar terms than it was a month ago. 



100 YEN 


Of course, the reverse could also happen. The exchange 
rate might increase to 150 yen per dollar. In this case, 
we say the dollar has strengthened, or appreciated, against 
the yen, because $1 now buys more yen than before. The 
precise dollar amount of the change is computed as follows: 
(3 million yen) x ($1/150 yen) ® $20,000, a decrease of $5,000, 


150 YEN 

$ 1 & 


The importer faces exchange rate risk, 
because in a month, the 3 million yen might 
be worth more or less than the current 
$25,000. This uncertainty makes it difficult 
to make a business plan. 

I can't know for sure how 
many cars ill want to import 
unless ! know what the price 
will be in dollars. 

You might wonder why the U.S. importer wouldn't just 
prepay for next month's car shipment at today's exchange 
rate of 120 yen per dollar. That would obviously eliminate 
uncertainty and reduce the exchange rate risk. One reason 
is that companies generally prefer to keep their money 
for as long as possible to earn interest on it. 

Besides prepaying, there's another 
way the importer can eliminate 
uncertainty. The importer can arrange 
a forward contract and Took in" the 
exchange rate so that the importer's 
cost of cars in dollars will be fixed. 

Now that I ve locked in 
my exchange rate, I know 
precisely how many dollars 
the car shipment will cost. 


To illustrate a forward contract, 
suppose that the 30- day forward 
exchange rate is 125 yen per dollar. 

Because the car importer has access 
to forward contracts, the expected cost 
of the 3 million yen needed to pay the 
Japanese car maker In one month is 524,000. 




30-0 AY 


[ 0.54 

ru nWfWlCD 


f / P011AR 

1 1.31 


/ EURO 1 

I 0.91 | 





1 SWISS f 



^ I'm better off holding ^ 
dollars than yen for the next 
month because Interest rates are 
higher in the United States 
L than in Japan. > 

One factor affecting forward exchange rates is 
I that Interest rates differ between countries, 
so people who hold the currency of a country with 
1 high interest rates can earn a higher return. 

Indeed, if interest rates are higher 
in the United States than in Japan, the 
likelihood increases that the dollar will 
strengthen relative to the yen. 

Other factors such as inflation 
expectations and economic 
conditions of a country, influence 
the value of its currency. 


the exchange rate 
increases or decreases, it won't 
affect the importers purchasing 
costs, since his exchange rate has 
already been determined in the 
V forward contract. > 

/ The car importer has H 'V 
r managed to reduce his > 
business risk because he knows 
with certainty how much 
s. the cars wilt cost in one J 
V month's time, 

The U,$. importer may arrange a forward contract through 
a large bank. The bank agrees to sell 3 million yen to the 
U.S. importer, in one month's time, at a forward exchange 
rate of 1 25 yen per dollar The import company is effectively 
paying the bank to assume some of its exchange rate risk. 

You should keep in mind that forward exchange 
rates are not precise forecasts of future exchange 
rates. Therefore, locking in a forward exchange 
rate creates some risk for a company because 
it may have locked in an unfavorable rate. 

r I would have ^ 
done better by waiting 
to buy the yen, j 

I anaa/caimci 
] PRICE: Si%ooo 

For example, if the actual exchange rate in one month is higher 
than 125 yen per dollar, the U,S. company would have benefited 
by not entering into the forward contract because the price per 
car is now less than 524,000. 







Some monetary authorities (central banks and finance ministries) are also actively 
involved in the foreign exchange market. They try to maintain stability in the marketplace 
for currencies, so that international trade can take place unimpeded. 


The monetary authorities of countries whose currencies aren't 
traded in targe quantities in the FX market can directly 
affect supply and demand conditions for the currencies. 

The krown has been ^ 
falling in value. Let's 
buy some krowns to pump 
. up its value. . 


For a country such as the United 
States, whose currency is actively 
traded in the FX market, central 
bank FX intervention is more likely 
to influence market sentiment 
than to alter demand and supply 
conditions for the dollar. 

Although there is 
no absolute rule 
determining when 
central banks 
might intervene, 
sharp and rapid 
exchange rate 
fluctuations unrelated 
to underlying economic 
conditions are 
signs that the central 
banks might take action. 


Your Iasi 

r offer for the \ 
r forward rate is f 05 yen 
per dollar? i think a 
more realistic forward 
rate is 1 10 yen per dollar* * 
Let’s wait until things 
L settle down in the 
foreign exchange A 
| market. 

A disorderly foreign exchange market can lead to 
economic instability. With increased fluctuation in 
exchange rates, it becomes more difficult and expensive 
to agree to market transactions, and companies 
may be unwilling to make commitments in foreign 
currencies. As a result, trade can suffer. 


* And that, 1 
we hope will put 
upward pressure 
on the dollar 
relative to 
V the euro. A 

The world's major central banks sometimes 
combine efforts to try to maintain stability 
in the foreign exchange market* 

8 So, we agree that the value of the 
dollar is dropping too sharply against the euro, 
and that we should do something to remedy the 
situation* We can try to do that by selling 



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Foreign trade and exchange are growing rapidly* For 
example, U.S* imports of goods and services now equal 
almost 17 percent of the annual output of the U.S* 
economy, almost three times the percentage of 35 years 
ago. International trade will continue to grow rapidly as 
markets become more global, and the growth of trade will 
continue to raise living standards in most of the world. 


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Federal Reserve Bank of New York 
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33 Liberty Street 
New York. NY 10045 
(212) 720-6134 


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